EUROPEAN UNIVERSITY INSTITUTE, FLORENCE
DEPARTMENT OF ECONOMICS
E U I
THE STOCK
AN
e x p o:
E R No. 87/288
JEHE EXCHANGE RATE:
CRITICAL APPRAISAL
obereÿrTAMBORINI
This paper is part o f a research which is being carried on at the European University
Institute o f Florence under the supervision o f Professor M. De Cecco. A first draft has
been commented on by Professor E. Phelps (Columbia University, N.Y., and Visiting
Professor at the E.U.I.). An unpublished paper kindly made available by Professor S.
Biasco (University o f Rome) has helped me to refine some points. I am fully
responsible for this paper.
BADIA FIESOLANA, SAN DOMENICO (FI)
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
reproduced in any form without permission of the author.
(C) Roberto Tamborini. Printed in Italy in April 1987 European University Institute
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
THE STOCK APPROACH TO THE EXCHANGE RATE:
AN EXPOSITION AND A CRITICAL APPRAISAL
INTRODUCTION
In the last decade, the confidence in a floating exchange-rate regime
and in particular the complete laissez faire of the United States since 1980
have been backed by a vast and authoritative literature which has enjoyed
absolute predominance in the profession. Such a literature can be grouped
under the label of the "stock approach to the exchange rate" . It was born
"to illustrate one -but only one- important channel through which changes in
asset-market conditions feed back on themselves through the exchange rate"
(Branson (1977),p.70). Then, it has become a well-established, self-
contained apparatus dictating exchange-rate theory and policy.
The stock approach to the exchange rate has come into use to tackle two
major challenges facing the world economy after the Bretton Woods system
broke down: exchange-rate "volatility" and international payments
adjustment. The distinguishing point of the new approach, as opposed to the
traditional "flow" theory, has been to look at the excange rate as an "asset
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
price" which is determined along with other asset prices in the equilibrium
process of asset markets. The asset the price of which is the exchange rate
may be domestic money (monetary approach) or a portfolio security
denominated in foreign currency (portfolio approach). This shift of focus
from international trade to asset markets is usually exlpained as a
consequence of a world of high or "perfect" capital mobility. The
outstanding conclusion is that exchange rates are volatile but not
unpredictable, nor are they disruptive of "fundamental" networks of
payments: capital movements make them fluctuate more or less roughly around
purchasing power parity or at least a standard consistent with current-
account balance.
The present paper offers elements for a critical evaluation of the
stock approach's predictions and prescriptions. The reader may find it
useful to keep in the back of his mind a few stylized facts which have
engendered present dissatisfaction with exchange-rate theory and practice.
True enough, exchange rates have ever shown short-run volatility; but the
most serious fact is that in the three major episodes of the dollar against
the mark and other key currencies -the steady fall in 1978-79, the sharp
rise in 1980-85 and the depreciation in 1986-87 (1st quarter) coupled with
increasingly large current-account deficits- exchange-rate dynamics and
trade imbalances did not show any reliable tendency to take care of
themselves through the capital account or through any other channel. Quite
the contrary, to break those trends coordinated interventions of central
banks were eventually necessary. Failures of such order of magnitude need
not be supported by econometric evidence, nor are they solvable by
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
econometric alchemy. The empirical and econometric literature on the
exchange rate falls outside the scope of our investigation, which is
essentially theoretical in aim.
In chapter I theory's foundations are exposed. A substantial effort has
been made in order to bring into light the essence of the stock approach,
since it has been obscured by a host of "practically-oriented"models. For
the same reason, formalization and "technicalities" are kept down to a
minimum. The main message is that, although the new approach was certainly
prompted by the observation of the enormous increase in international
capital mobility,-it has mainly remained an internal development of the "New
Macroeconomics" in the Pigou-Patinkin vein. After having acknowledged the
importance of stock equilibrium in macroeconomcis, chapter II points out
some pitfalls in the stock approach which have become major flaws in
exchange-rate theory; in particular they affect the modelling of the
exchange market, of wealth effects and of the macroeconomic process.
Conclusively, it is argued that such flaws in fact account for major
failures of today's exchange-rate theory; it seems desirable to open up the
stock approach to contributions to financial economics coming from outside
the framework of the New Macroeconomcis and, at the same time, to rebalance
the asset-market perspective with a careful reconsideration of the
interrelations among exchange rate, production and international trade.
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
There are several possible ways of searching for leading principles in
the vast and varied group of stock theories of the exchange rate (l).Here,
such a task will.be pursued by framing exchange-rate theory within its
natural setting of the so-called "New Macroeconomics" . As a matter of fact,
it is the latter the source of leading principles for the former; in
particular, attention should be paid to the evolution of today's open
economy macroeconomics from earlier neo-Keynesian macroeconomics (that is to
say the traditional IS-LM apparatus)(2).
Next, a "standard" portfolio approach to exchange-rate determination
will follow; "standard" in the sense that it will be based on those
principles and assumptions that seem to be crucial to this approach, while
the very many variations on the theme will be disregarded (3).
1. Methods of Equilibrium
1.1. New Macroeconomics has grown out of the critical revision of
formal conditions of equilibrium adopted, explicitly or implicitly, in
Keynes's theory and later on in neo-Keynesian macroeconomics. The core of
such a criticism is the statement that a true equilibrium position of the
system cannot be attained to so long as there are changes in stocks; such
changes and their consequences on the macroeconomic process should be
modelled explicitly (4).
Such macroeconomic flows as saving, investment, government deficit,
commercial and financial international transactions, including those of
official reserves, all have effects on their own underlying stocks, and in
principle it cannot be assumed that those stocks will increase or decrease
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
indefinitely without feeding back onto flows. In the IS-LM system , for
instance, the only stock equilibria explicited are those relative to money
and official reserves. Mundellian internal-external equilibria are based on
the implicit assumption that at a given level of the interest rate the stock
of domestic bonds held by residents and/or foreigners can be increasing or
decreasing permanently. On the contrary, it is argued, equilibrium must
hold for flows and stocks simultaneously.
1.2. Traditionally, in economic theory the norm of "full equilibrium"
is given by the conditions of the so called "steady state". In its static
version it requires each and all stocks and flows to be at their desired
level and to be unchanging. This implies that saving and net investment must
be null and the whole disposable national income be spent on consumption
goods and on the maintenance of the existing stock of capital goods.
Moreover, the government budget must be balanced, so that the public debt
(if any) does not change, the current account must be zero and there cannot
be transactions on capital account,so that the stocks of foreign assets and
liabilities do not change. Financial assets consist of perpetuities yielding
an income flow which is entirely consumed (5).
In New Macroeconomics the focus on stocks has two outstanding
methodological consequences derived from steady state conditions: flows
matter to the extent that they alter stocks, altered stocks are re-adjusted
to their steady-state level.
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
2. Steady state, portfolio equilibrium and the exchange rate
2.1. Let us consider a small open economy, the most usual topic in
modern open macroeconomics. "Smallness" . is generally translated into the
following assumptions:
(i) Economic conditions abroad are parametrically given and domestic
phenomena do not affect them. In particular, price and quantity of exports
are given by world market conditions.
(ii) No domestic assets are held abroad.
(iii) Residents hold foreign assets (it may prove useful to think of
interest-bearing deposits abroad).
"The exchange rate" is the nominal price of 1 unit of the composite
currency of the country's trading partners (without loss of generality one
may think of a "world-trade currency" called "dollar").
2.2. In the neoclassical steady state (6) full flexibility of wages
and prices keeps production factors fully employed. To this end a major role
is played by "real balance effects", that is to say gains or losses on
capital account affecting the purchasing power of wealth (money) holders,
which are entirely transmitted to the demand for output thanks to the "gross
substitution principle" between money and real assets (otherwise known as
Walras Law). In the small open economy with fixed exchange rate the interest
rate is continuously equal to the world interest rate; for domestic
securities are perfect substitutes with foreign securities and there exists
continuous stock equilibrium (7).The foreign sector is one of the channels
through which domestic wealth holders restore the desired real value of
their money balances in the event of a nominal shock. Consider an excess
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
creation of money: purchases of foreign goods and a rise in the domestic
price level (due to excess demand also for domestic output) both help to
restore stock equilibrium. International payments imbalances reflect stock
adjustments taking care of themselves (8).
In the steady state the exchange rate must be at its value of
"purchasing power parity" or, that is the same, the Law of One Price must
hold. Were it not so, there would be opportunities for some residents to buy
foreign goods or for some foreigners to buy domestic goods (9).
The Law of One Price implies that "the" real exchange rate is equal to
one. As is well known, one problem here is that there may be as many real
exchange rates as price indexes. In the stock approach,the real exchange
rate (t) is a determinant of the real value of wealth holders' money
balances (M) in proportion to the weight of tradable foreign goods in the
price index (P) relevant to their purchasing power:
(1) M/P = Mq
d
(2) P = P a + eP*b a + b = 1 d
= P (a + tb), if t = 1
where (P ) is the domestic price index, (P*) is the price index of foreign
goods and (Mq ) is the desired real money stock.When the real exchange rate
is equal to 1 wealth holders' price index is equal to the domestic price
level, i.e. purchasing power parity holds (10).Accordingly, deviations of
the exchange rate from purchasing power parity affect wealth-holders'
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
demand for foreign real assets and, as a substitution effect, for domestic
real assets too.
In the steady state, by pure manipulation of the definition of real
money stock (1), the exchange rate thus takes the form of the "price of two
monies" (M/Mq)/(M*/M£), that is to say the price of world money at which the
domestic stock of money is willingly held (11).
2.3. If the exchange rate is freely floating, stock adjustments after
nominal shocks are reflected in exchange-rate changes instead of
international payments imbalances? the adjustment in the exchange rate and
in the domestic price level will go on until purchasing power parity and the
desired real money stock are re-established .
In most authors' thought, when the exchange rate is fully flexible
excess demand-supply of foreing asset becomes the source of adjustment of
the money stock . To this effect, the model of the exchange market has to be
augmented with the forward rate and the expected spot rate for the same
term. In fact,under the assumption of perfect market, the equilibrium
forward premium (discount) equalizes the interest differential, and at the
same time it is equal to the expected depreciation (appreciation) rate;
thus, although the nominal interest differential is always null, whenever
the expected rate of change spot is not null opportunities to exploit
uncovered interest parity develop (12).
Obviously, the crucial problem remains of explaining the expected rate
of change spot, a matter we shall not go deeper into. Suffice it to say that
if such a rate is the rate of change tending to purchasing power parity
according to the outcome of the "structural model" (plainly, the inflation
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
differential or the money growth differential), we enter the domain of
rational expectations. Thus, if the money growth differential is positive,
the exchange rate is expected to depreciate, uncovered interest parity
becomes negative, excess demand for foreign asset develops. Capital outflows
need not take place materially: the exchange rate is instantaneously
adjusted to its purchasing power parity value or relative purchasing power
parity continuously holds (13).
By definition, rational expectations do not alter the final result of
the "structural model", that is the best predictor of the actual system's
behaviour; they simply "anticipate" it. This last circumstance is not
crucial to the purpose of the present work, whereas to expound properties of
"structural models" is much more important .
Indeed, fundamental propositions in modern exchange-rate theory rest
upon the behaviour of "pure savers" ("widows and orphans" in jargon), that
is to say agents who aim at maximazing the income flow out of their
financial wealth without bearing risks on capital account; gains or losses
on capital account are windfalls affecting the value of their wealth,but
these are not the objetc of their wealth management. In other words, pure
savers do not plan to sell securities before their maturity, unless
unexpected events occur or unless a new issue (actually) pays a higher
interest rate. It is pure savers' behaviour that pertains to the "structure"
of markets on which speculators form their expectations and in which they
carry on their plans (14).
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
Static expectations, such that the expected exchange rate is always
equal to the actual one, will be the normal assumption in the following
(unless otherwise stated and discussed) (15).
As we have seen, the standard monetary model is essentially a
speculative model (McKinnon (1979), ch.VIII), but as far as the "structural
model" is concerned, the monetary-approach writers seem to fail to show the
link beteewn the domestic money market and the exchange rate (see also the
criticism by Kouri (1983), pp.116-117)). With static expectations regarding
the exchange rate , there is no room for adjustments through the capital
account like in the case of fixed exchange rate (see n.a, p.5). A part of
the stock adjustment has to take the form of purchases or sales of goods on
the foreign market,thus moving the exchange rate. It is not clear,then,what
is the meaning of the common belief in the monetary approach according to
which conditions of international equilibrium "have nothing to do with the
elasticities of (national) excess demands for and supply of traded goods as
functions of their real prices" (Johnson (1977), p.259).). Quite the
contrary, it seems necessary that for purchasing power parity to be re
established well-behaved elasticity conditions must hold (see the
fundamental analyses by Robinson (1937) and Machlup (1939)).
Stock and flow equilibrium must be reached simultaneously. But since
the exchange rate and the domestic price level are moved on different
markets, though by interrelated forces, in general they cannot be expected
to change proportionately at once; a certain degree of "overshooting" -i.e.
temporary violation of purchasing power parity- may be embedded even in a
steady world of perfect markets (16).
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
2.4. A cornerstone of neo-Keynesian macroeconomics retained in the
stock approach is liquidity preference as a "behaviour towards risk". Wealth
holders attach different degrees of liquidity risk to different assets in
the fear of unexpected liquidity needs. Even in the steady state, when
ecenomic events can be perfectly foreseen, life events cannot. In this
view, capital-income maximization requires portfolio diversification and,
in equilibrium, different rates of return (not necessarily nominal interest
rates) among assets, reflecting different liquidity risks (17).As far as
foreign assets are concerned, the major component of risk is exchange
risk(18).
At this point it should be stressed that portfolio theory is not merely
an extension of the neoclassical monetary theory to a multi-asset world
(the neoclassical theory does not hinge on a simplistic model of assets).
Money and real assets are at the opposite ends of the liquidity spectrum,
and,because of liquidity-preference considerations, portfolio balance is
realized through substitution among assets situated between the two ends. In
other words there is no longer direct substitution between money and real
assets and the output market is affected only indirectly, through asset
prices.
Continuous and instantaneous stock equilibrium, price vectors at which
agents willingly hold existing stocks, are consistent with the situation of
steady state. But outside the steady state, macroeconomic flows entailing
financial flows do take place; these asset flows must be accomodated in
wealth-holders' portfolios. The equilibrium price vector now consists of
output prices, asset prices and the exchange rate (19).
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
Consider n assets (A.,, i = l...n).The rate of change of their stocks
must amount to the formation of financial wealth (saving flow) or of "net
financial wealth" (W) (saving minus net investment) in the same time
unit(20). As usual, we shall follow the latter specification by considering
shares on net investment as the n-th asset. The wealth constraint allows for
the determination of equilibrium conditions for the (n - 1) "outside" assets
(Vr, j = l...n - 1), given respective initial stocks (VTq ) and within-period
supply flows (Hj). Each asset stock is intended to be equal to its nominal
value times the asset's price index (q _.). Money's price index is always 1.
The conventional assumption that money does not bear interest leaves (n - 2)
outside assets' return rates (rj) to t>e determined endogenously. Rates of
return are determined by the respective security's price index (q..) given
its nominal interest rate (r.) (r. = r./q.). j J 3 j
Then, n equations can determine ((n - 2)r^, Y, e), where (Y) is money
income and (e) is the exchange rate:
(3) (4) W. ( * ) = H. + W. 3 3 3 0 >.W. = D + X + W *“3 3 O
where (D) is the government budget and (X) is the current account.
Three are the most important arguments usually included in functions
(3): the own return rate (r^), money income (Y) and a wealth term (w). An
increasing own return rate shifts demand to that specific asset from other
assets, that it to say it gives rise to a substitution effect (21).
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
An increasing money income raises demand for all assets, that is to say
it brings about an accumulation effect which is specular to marginal saving.
Undesired changes in real wealth bahave like changes in money income, but in
the opposite direction. If real income is at the level of full employment, d
so that the endogenous variable is (P ) the domestic price level, and there
is no money illusion, income effects disappear and only wealth effects
remain. Overall wealth effects captured by (w) should not be confused with
specific wealth effects given by changes in (q^)'s in equations (3).)
To focus on the small open economy with flexible exchange rate, let us
consider only 3 outside assets (j = 1 money, 2 government bonds, 3 a foreign
asset) (22).
In stock equilibrium, the level of money income is given, saving, net
investment, government deficit and current account are all null. As clear
from equation (4) nominal wealth must be unchanging. Establishing portfolio
equilibrium involves the exchange rate through the following interrelated
channels:
(i) the exchange rate is a positive function of excess demand of foreign
currency;
(ii) the exchange rate enters the determination of the foreign asset's
return rate for domestic buyers, as it converts the foreign asset's market
price into domestic currency (q^ = eq*);
(iii) the exchange rate determines the current value of the stock of foreign
asset expressed in domestic currency(W3o = eqJW*).
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
In portfolio analysis of the small open economy the above three
channels of determination of the exchange rate lead to a peculiarly well-
bahaved asset substitution such that a unique equilibrium relationship
exists between the domestic rate (r2 ) and the exchange rate (e) , the third
asset market being brought into equilibrium by quantity adjustments(Branson
(1977), I.)
Reconsider now an excess creation of money. Excess money will spill
into other asset markets lowering the domestic rate and raising the exchange
rate. Since outside supply of bonds and foreign asset is fixed, and since
inside wealth-holders' expectations are uniform (23), there will be no
quantity but only price adjustment of existing stocks towards portfolio
equilibrium. The rise of the exchange rate helps portfolio equilibrium by
lowering the return rate on the existing foreign asset and by increasing the
domestic value of its actual stock. The effect on the exchange rate is
larger the better substitutes are domestic and foreign assets . The effects
of the exchange rate must be stronger the smaller are changes in the foreign
asset's price.
According to the well known portfolio approach's aphorism,"the exchange
rate is an asset price". It should be clear that this is somewhat different
from the generalization of the monetary approach's aphorism that "the
exchange rate is the price of monies". First of all because of monetary-
theory considerations.Moreover, in both approaches the exchange rate moves
in order to keep stock equilibrium, but in the monetary one, as long as
expectations are static, the exchange market can be affected only by
commodity transactions, whereas in the portfolio one the exchange market is
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
affected directly by financial transactions. A most striking feature of the
latter is in showing the possibilty, a crucial one indeed, that the exchange
rate changes with no actual transactions on the market, as in the above
example of the steady state. In that case, portfolio adjustment made the
exchange rate rise though no record appeared in the balance of payments and,
what is more important, though no change occured in international trade or
its determinants. This is in fact the outstanding achievement of the stock
approach in the explanation of the so-called "exchange-rate volatility" in a
system of high capital mobility (24).
3. The current account-capital account relationship through wealth effects
3.1. We ended our treatment of the steady state and portfolio
equilibrium by stressing that pursuing portfolio equilibrium can move the
exchange rate independently of international trade determinants. Hence, the
portfolio-equilibrium exchange rate may be inconsistent with international-
trade equilibrium, for instance because it is no longer the purchasing-
power-parity exchange rate. It is natural to maintain that departures of the
exchange rate from purchasing power parity affect international trade
through a real balance effect, as described above (2.2), which now regards
not only money but the whole financial wealth. Therefore, a depreciation
will cause a positive trade balance and v.v. an appreciation. This is one
way of looking at portfolio equilibrium as a so called "short-run
equilibrium" (25).
At the same time, real depreciation will normally be accompanied by
domestic inflation and real appreciation by domestic deflation. In both
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
cases, the real exchange rate may be partially self-corrected. The crucial
question is whether trade imbalances have corrective effects on the exchange
rate and on themselves.
3.2. The traditional answer to the above question is yes, provided
that there exist well-behaved demand and supply functions on the exchange
market reflecting well-behaved demand and supply functions of international
trade.
When the exchange rate is freely floating a current account imbalance
is first of all equal to a change in net financial wealth (as clear from
equation (4), cet.par.) in the form of claims on foreigners.In the stock
approach, this is meant to be an accumulation wealth effect which requires a
further stock adjustment in the opposite direction in order to re-establish
portfolio equilibrium. It is precisely such a further stock adjustment to
move the exchange rate after a current account imbalance (26).
Thus, if we start from a portfolio equilibrium entailing an appreciated
currency, there will be a current account deficit and therefore a loss of
foreign asset followed by an excess demand of foreign asset (possibly an
excess supply of domestic bonds and money) and a currency depreciation (a
domestic return-rate increase). The process will go on until depreciation
will have restored purchasing power parity and current account equilibrium.
Changes in the domestic price level may play a helpful, but not necessary,
role (Branson (1977), III) (27).
3.3.To sum up we have a framework in which:
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
(i) the exchange rate affects the current account, but endogenous or
exogenous imbalances of the current account do not affect the exchange rate
directly but only through the wealth effect on portfolio;
(ii) the traditional negative relationship between current account and
exchange rate (the deficit country depreciates at a rate given by the ratio
between the current deficit and the stock of foreign asset ) is obtained
because ex ante excess demand of domestic currency on capital account takes
the same sign as the current account;
(iii) the movement towards the steady state is period by period along a
succession of portfolio equilibria, but the adjustment path depends on the
current account's elasticity to the real exchange rate.
No doubts,portfolio theorists look at such a framework as a theory of
exchange-rate dynamics capable of generating propositions of general
validity
In the short-run, the exchange rate is determined by asset-market equilibrium conditions. In the longer-run, as asset stocks, especially foreign assets, change, the exchange rate moves towards the value which balances the current account (Branson (1977), pp.83-84),
and, empirically,
if the major industrial countries are arrayed from the ones with the largest surplus to the largest deficit, that array provides a good prediction of the rank order of appreciation and depreciation (Branson (1980), p.191).
II. PITFALLS IN THE STOCK APPROACH AND FLAWS IN EXCHANGE-RATE THEORY
Exchange-rate theory in modern macroeconomics lends itself to a
complex, many-sided appraisal. The first, and most significant,step would
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
take us to the theoretical roots of New Macroeconomics, since, as shown in
the previous chapter, exchange-rate theory is founded on them. One might
then argue that exchange-rate theory takes for granted a number of
(Walrasian) properties of a market system which are still debated or even
seriously questioned (28).
A second, more specific, evaluation would focus on the assumption of
efficient market underlying exchange-rate theory. In this connection, one
might question the existence of efficient markets even in today's
ubiquitous, electronic, highly integrated financial world. There is still
evidence of unstable demand functions, slackness in stock and price
adjustments, conflicting expectations. Portfolio choices embody much more
than neat probability calculus can explain (29).
In the following we shall depart from those routes and we shall limit
ourselves to what is usually called an "internal critique", that is to say a
critique which does not put under question assumptions and views of the
world,but modelling and reasoning, with particular regard to "standard"
protfolio theory of the exchange rate as set forth in ch.I .
The main critical focus will be on pitfalls in the stock approach.
Attention to stocks has been a major step forward in macroeconomics. The
question is to what extent such an approach and its usual applications are
consistent with actual economic processes? in simple words, how and how much
stocks matter. Firstly, it will be shown that standard portfolio theory,in
order to attain to well defined results about exchange-rate determination,
hinges on a questionable modelling of the exchange market of the small open
economy (not to say about large, interdependent economies).Secondly, what
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
is more important, the idea of explaining the current account-capital
account-exchange rate relationship "without reverting to the traditional
flow theory of foreign exchange" (Frankel (1983), p.95) is based on a
logical misinterpretation of the balance-of-payments identity as a wealth
effect. Finally, some further remarks will follow concerning results that
can be obtained when standard modelling is abandoned and portfolio
adjustments are more carefully embodied in the macroeconomic process.
1. Pitfalls in modelling the exchange market
1.1. There are several aspects of exchange-rate determination in
standard portfolio theory deserving closer inspection. A microeconomic
example will serve the purpose. Note that the example is not arbitrary, but
it focuses assumptions and properties that are crucial in portfolio theory.
A natural extension of the small open economy conditions is to consider
competitive small international traders. Exports and imports are both
invoiced in dollars, the world-trade currency. At least all unexpected
payments are converted on the spot market. International payments are
recorded in the balance of payments at their contractual value; traders
bear gains or losses in domestic value due to the actual exchange rate at
which they convert their dollar balances. Traders are the (risk-speculation-
averse) agents who hold the economy's foreign asset in the form of dollar
deposits abroad, where their natural business environment is located. The
stock of foreign asset must be in balance with stocks of domestic-currency
(say, "lira") assets.
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
Let us focus on an iternational trader who holds 1000 dollars abroad
equivalent to 1.6 million liras at the current exchange rate, and who is
faced with an unexpected imbalance of payments abroad for 100 dollars. What
is implied by standard theorizing is that the trader will first withdraw 100
dollars from his deposit. Now the deposit amounts to 1.44 million liras and
is out of portfolio balance. Then the trader will try to restore portfolio
balance by demanding dollars and supplying liras. Since no one accepts liras
against dollars outside commodity trade, the exchange rate will be bid up to
that value which makes 900 dollars be 1.6 million liras worth, that is to
say 1777.8. The depreciation rate of the lira has been (approximately)
equal to the rate of decrease of the foreign asset stock. The balance-of-
payments accounting in liras is as follows:
Tab.1.____________________
Current Account
Imports
Capital Account
Decrease in foreign assets
-160000
+160000
If depreciation exerts its expected effects, there will be a step-by-
step reduction of the current account deficit up to zero, accompanied by
decreasing reductions of the foreign asset stock at a constant domestic
value.
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
1.2. "Smallness" is a crucial, though not indispensable,assumption in
portfolio theory of the exchange rate. In fact, such an assumption rules
out, or is supposed to rule out, some otherwise important phenomena which
could weaken or even reverse the effects of portfolio adjustments on the
exchange rate (within the portfolio framework itself). Such phenomena are
mainly the following:
(i) relatively higher substitutability among domestic assets vis a vis the
foreign asset;
(ii) exceedingly large stock of the foreign asset in relation to a given
current account imbalance;
(iii) endogenous changes in the price of the foreign asset;
(iv) endogenous rise of an elastic supply of foreign currency on capital
account.
The absence of the first three phenomena is usually taken for granted,
while the absence of the fourth is deduced from the corollary of non
marketability of domestic assets (30). Before briefly discussing the
relevance of such a situation, it is important to notice some pitfalls.
1.3. Domestic non-monetary assets are not traded on the exchange market
directly. Sales and purchases of securities first require a currency
transaction; it is this currency transaction that passes through the
exchange market. For no supply of foreign currency to develop the true
assumption should be that what is not marketable is domestic money , which
seems to be inconsistent with the existence of international trade.
Let us take again the example of our small trader. It is sufficient to
suppose that what the trader wishes is not a given domestic value of his
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
dollar deposit, but a given dollar amount of it in relation to his business
needs. In this case, the trader would demand for exactly 100 dollars and,
without supply of dollars, the exchange market would never clear (31).
1.4. It may be shown that supply of foreign currency can arise even
though domestic securities are not held abroad. As a consequence, however,
two new problems undermine the neatness of standard results: the
characteristics of the supply of foreign currency, and the degree of change
of the exchange rate. Indeed, depending on the former problem, the
equilibrium exchange rate may now lie anywhere between the initial value and
the maximum value, that would be reached with no transactions .
Consider again the small trader facing the problem of rebalancing his
portfolio. At the initial exchange rate he demands 100 dollars against
160000 liras. He is making use of lira balances and/or proceeds from sales
of lira bonds to residents (the fall in their price may help to restore
portfolio balance). Then, for instance, the two following possibilities may
arise:
(i) at an increasing dollar price, supply of dollars may come from resident
exporters;
(ii) at an increasing dollar price (spot), arbitrage opportunities develop
at the given interest-parity forward rate, so that dollars are sold spot and
bought forward (32).
The point is that in the two possibilities the elasticity of supply of
dollars is likely to be different, so that the equilibrium exchange rate is
likely to be different. For instance, exporters may be expected to have an
equilibrium function of the foreign asset similar to importers'; the demand
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
for dollars of the importer could be met more or less halfway, say 41
dollars at 1700 (the importer thus increases his deposit up to 941 dollars
being 1.6 million liras worth). The balance-of-payments recording is now
the following:
Tab.2._________________________________________________
Current Account
Imports -160000
Capital Account
Decrease in foreign assets
Increase in foreign assets
Decrease in foreign assets
+160000
-69700
+69700
On the other hand, profitable arbitrage may be made even with a slight
increase in the dollar price. Suppose then the trader can realize his
operation by buying 70 dollars at the spot rate 1650 (in fact, he now owns
970 dollars equivalent to 1.6 million liras).The operation is recorded as
following if the arbitrageur is non-resident:
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
Tab.3._________________________________________________
Current Account
Imports -160000
Capital Account
Decrease in foreign assets
Increase in foreign assets
Increase in foreign liabilities
+160000
-115500
+ 1155.00
Of course, overall sums in tables 2 and 3 are identical to that in
table 1; however,the three tables reflect three quite different operations
and, what is more important, different equilibrium exchange rates.
1.5. When allowance is made for domestic securities marketability, a
third possible source of foreign currency adds up to those singled out
above. A falling dollar price of the lira induces foreign holders of lira
bonds to relatively increase their holdings, thereby demanding liras against
dollars (the concomitant rise in the lira price of lira bonds can lighten
the burden of the exchange-rate's adjustment). The recording would be
similar to that in tab.3, but what would the actual figures (and the
exchange rate) be? Notice that the usual rationale of the stock approach -
that in today's exchange markets arbitrageurs and traders normally cannot
match the mass of financial transactions- does not apply in this case, since
we are considering just the financial side. On the other hand, if one wishes
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
to model explicitly supply of foreign currency, or the function of
indebtedness abroad, one should admit that there are no good reasons to
expect such a function to posses well-defined general properties. At any
rate, for international portfolio adjustments to be effective on the
exchange rate there should be different portfolio preferences through
countries. A crucial assumption in this respect is "home currency
preference", according to which each country's wealth owners prefer to hold
a larger share of their total and marginal saving in domestic-currency
denominated assets (33).
It is reasonable to argue that the more sources of foreign currency are
considerd the less predictable is the exchange-rate change on an a priori
ground. In this view, working on such an aggregate as"Net Foreign Assets"
(as in most stock models) is highly misleading, both from a flow and a stock
viewpoint. In our previous examples the same change in "Net Foreign Assets"
is associated with three different exchange rates. "Net Foreign Assets" is
an ex post item, while what drives the exchange rate is ex ante excess
demand and supply. In sum, even allowing for a well-behaved demand for
foreign asset, when supply of foreign currency may develop, a condition
which should be regarded as normal no matters whether domestic assets are
held abroad or not, portfolio adjustments affect the exchange rate in an
unpredictable degree.
2. Pitfalls in wealth effects
2.1. Let us now come to the core of exchange-rate dynamics in standard
portfolio theory: current account imbalances as wealth effects.
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
Ex post, with a freely floating exchange rate, it is always true that
a current account imbalance is equal to a change in "Net Foreign Assets" by
the same amount. There are two major problems with portfolio-theory's
interpretation of this balance-of-payments identity (refer to 1.3 and to the
example in II.1.1)
(i) that the change in "Net Foreign Assets" is always ex ante as well;
(ii) that the change in "Net Foreign Assets" is always a wealth effect.
Interpretation (i) is necessary for the current account not to have direct
effects on the exchange rate; interpretation (ii) is necessary for exchange-
rate dynamics towards the steady state.
2.2. In the normal course of business (and the normal modelling of it),
commercial payments abroad are not financed with ex ante withdrawl of
foreign assets on the part of importers unless someone wishes to do that.
In general, importers can be expected to go through the exchange market
directly in order to raise the foreign currency they need for their
settlements. In other words, in general ex ante demand on current account
should be regarded as independent of ex ante demand on capital account.
It is precisely the exchange-rate change that, likewise whatever else
price, must make demand on the one side meet supply on the other side,
thereby clearing the market and realizing the observed ex post identity.
Thus, in order to meet the importer's demand for foreign currency someone
else should release foreign assets and accept domestic liabilities; and this
is accomplished by an appropriate change of the exchange rate.
Therefore, in general it is not true that the current account has no
effetes on the exchange rate but through the capital account, while it is
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
true that the current account has effects on the capital account through the
exchange rate (and v.v.) (34).
Given the short-run equilibrium value, the exchange rate must change per unit of time in such a way as to equilibrate flow demands for and supplies of foreign exchange derived from capital flows on the one hand and current account transactions on the other (Kouri (1983), p.117).
In this view of the exchange market, the question of the existence of
an elastic supply of foreign currency becomes essential, and considerations
previously made on the matter (see above II.1.3 and following) apply to a
greater extent. Now an excess payment abroad should normally be regarded as
a fixed amount of foreign currency that must be supplied. The exchange rate
is bid up directly? in this way, domestic holders of foreign asset,
exporters, arbitrageurs, and, if the case, foreign holders of domestic bonds
-to mention potential suppliers of foreign currency presented in II.1- are
induced to meet the importer's excess demand. Again, there are no a priori
reasons to expect one particular kind of supply to prevail on the others and
to expect the equilibrium exchange rate to be fixed at one particular value
between the initial one and the maximum one (that with only domestic holders
of foreign asset as suppliers). Puzzles inherent in tables 1-3 of our
example of the small trader are still present.
2.3. The interpretation of current account imbalances as wealth effects
on "Net Foreign Assets" which straightforwardly entail a subsequent stock
re-adjustment is highly questionable, whether the current account is
financed ex ante by international traders or ex post through the exchange
market.
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
Pigou's wealth effects are undesired windfalls, gains or losses on
capital account brought about by changes in commodity or asset prices (apart
from "helicopter" phenomena affecting asset stocks). This nature of wealth
effects safely implies that stocks will be promptly corrected to their
initial level. Outside these phenomena, portfolio theory itself shows that
accumulation of wealth is always in specific forms, and it explains how
those specific forms of wealth come to be willingly held in the public's
portfolios.At the equilibirum price vector flows are exhausted, stocks are
willingly held and unchanging; this is precisely the task of prices.
Specifically, if an importer settles a payment by means of his dollar
deposit instead of other sources,one should conclude that he wishes to
reduce his deposit,and this is a stock equilibrium. On the other hand, if
the importer does not wish to dishoard his dollar deposit he will go through
the exchange market and the exchange rate will be fixed at that value at
which someone else will be willing to reduce his own dollar deposit;this is,
once again, a stock equilibrium. Actually, windfall wealth effects are
already embodied in such a process in response to changes in the exchange
rate, in asset prices and in commodity prices as shown throughout ch.I.
In modern macroeconomic theory there is no clear foundation of the
widely held assumption that if at a point in time the equilibrium stock of
an asset or of wealth has grown, it will necessarily be reduced over
subsequent periods (and v.v.). Unless specific accumulation functions are
modelled, the direction of "long-run" adjustment of stocks, if any, is
unclear and, therefore, it seems arbitrary to assume that (t) stocks will
sistematically be brought back to their (t - 1) level.Each stock equilibrium
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
is consistent with steady state conditions: it is nonetheless a "restricted
equilibrium" (this term is due to Hicks (1979), ch.VI) because the
circumstance whether equilibrium stocks are higher or. lower than initial
ones has no instantaneous consequences, but is "transmitted to the future"
(Tobin). Therefore, either accumulation is mistaken for windfalls or it is
implicitely presumed that, beginning in steady state, wealth holders
eventually wish for each and all asset stocks just the real value of the
initial steady state (that is often called the "long-run" equilibrium stock)
independently of changes in economic variables, specifically in asset prices
and the exchange rate. This in turn seems a fairly strong presumption, even
for a steady state economy (35).
What the stock approach can safely maintain is that once asset flows
have been willingly allocated in wealth-holders' portfolios and stock
equilibrium is reached,it can be disturbed only by external shocks stemming
from prices . Accordingly, what can be maintained is that a persistent
current account imbalance requires a period-by-period portfolio adjustment,
but bearing in mind that, cet.par., it is the current account that must
move the exchange rate properly. If the current account in turn properly
reacts to exchange-rate changes a steady state position will be reached
where the current account is null.
In order for the foreign exchange market to stay in equilibrium, domestic currency must depreciate whenever the current account is in deficit and appreciate whenever the current account is in surplus (Kouri (1983), p.118).
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
3. Stock equilibrium and the macroeoconomic process
3.1. The requirement for the steady-state solution set out above -that
the current account must properly drive the exchange rate and hence the
capital account- is the crux of the matter of international payments
adjustment under a floating regime, but working out exchange-rate theory
under conditions of neoclassical steady state has loosened connections
with actual macroeconomic processes.
3.2. In actual macroeconomies asset flows never occur one by one;
governments' budgets are normally unbalanced and pour money and bonds into
portfolios; firms normally do make net investments by borrowing from banks
and savers. What is more, multi-asset flows may be endogenously generating
one another (for instance,because of changes in asset prices if nothing
else).
In addition to the current account, the financial counterpart of the
government budget and of net investment must be accomodated in portfolios,
too. It is reasonable to think that also foreign portfolios can take part
to the adjustment (36).
As explained in II.2.1, the exchange rate should be moved so that ex
ante demand and supply on the exchange market are brought into balance, the
sign of the movement being dependent on which of the two is in excess. As a
consequence, when the current account, the government budget and net
investment all call for financing, a share of which goes through the
exchange market, the movement of the exchange rate can be either way. A
plausible assumption may be that a current-account deficit country is also
a budget-deficit country, and then a country where return rates are rising.
©
The
Author(s).
European
University
Institute.
version
produced
by
the
EUI
Library
in
2020.
Available
Open
Access
on
Cadmus,
European
University
Institute
Research
We may still regard excess demand on current account as a rigid need for
dollars, but now it may be outweighed by an excess supply of dollars
against liras on capital account underlying purchases of lira bonds . These
purchases may come from residents as well as foreigners. The market will
clear thanks to an appreciation of the lira, and it will be so as long as ex
ante demand for liras will exceed ex ante demand for dollars -i.e. so long
as the "real" side of the exchange market cannot overcome the "financial"
one (37).
The main lesson from the above is that when the exchange market is
modelled correctly, and when multi-asset flows are admitted, the stock
approach has to give up not only well-defined results about the exchange-
rate's rate of change but also about its direct ion. This has been recognized
in the literature only recently (Branson-Buiter (1983)), but it is not
realized that this has also strong implications on the time horizon of the
adjustment. Here, the capital account matters in determining exchange-rate
dynamics because the so-called "short-run" portfolio equilibria, where the
exchange rate and the domestic value of the current account are adjusted to
the capital account instead of the other way round, may actually persist.
Someone has pointed out that the accumulation wealth effect of the current
account should be regarded as an intertemporal effect, and that what matters
is "cumulated surpluses and deficits" (Frankel (1983), p.93). But this
restatement does not seem sufficient to overcome the questions raised above.
Paradoxically, it weakens portfolio theory by reducing it to the trivial
prediction that stock changes in the same direction cannot be acceptable
indefinitely. The obvious question is how far the stock change will go. If
